How Does The 1031 Exchange Work?
Prior to the close of escrow on the Relinquished Property, documents such as the Preliminary Title Report and Sales/Purchase Agreement is supplied to the Qualified Intermediary. The Exchanger enters into an Exchange Agreement with Qualified Intermediary. This requires that (a) The Qualified Intermediary acquires the Relinquished Property from the Exchanger and transfers it to the buyer by direct deed from the Exchanger. (b) The Qualified Intermediary acquires the Replacement Property from the seller and transfers it to the Exchanger by direct deed from the seller.
Note that cash or other proceeds from the Relinquished Property are assigned to the Qualified Intermediary and are held by the Qualified Intermediary in a separate, secure account. The exchange funds are used by the Qualified Intermediary to purchase the Replacement Property for the Exchanger. Any cash or monies received from the transaction by the Exchanger is taxable Boot.
Rules and Considerations for The 1031 Exchange
Exchanges must be completed within strict time limits. (1) The Exchanger has 45-days from the date the Relinquished Property closes to “Identify” potential Replacement Properties (This involves a written notification to the Qualified Intermediary listing the addresses or legal descriptions of the potential Replacement Properties). After time has elapsed on the 45-day Identification period the Exchanger cannot change their property identification list and must purchase one of the listed Replacement Properties. The failure in this process disqualifies the use of the 1031 Exchange.
(2) The Exchanger has 180-days after the close of the Relinquished Property to complete the purchase of the Replacement Property.
Three General Rules
To avoid payment of capital gain taxes the Exchanger should (1) Purchase a Replacement Property that is Equal or Greater in value than the Relinquished Property. (2) Reinvest all of the exchange equity into the Replacement Property. (3) Obtain debt on the Replacement Property Equal or Greater to that of the Relinquished Property. (The Exchanger can offset the amount of debt obtained on the Replacement Property by putting the equivalent amount of additional cash into the 1031 Exchange Transaction)